02 December 2012

Give Cuts A Chance

By Veronique de Rugy

A few days ago, the president announced
that he would be holding firm on his demand for $1.6 trillion in new tax
revenue from the rich as part of any deal he would make to address the
"fiscal cliff" and our debt problem. In theory, the president promises
some spending cuts. That's what he calls the "balanced approach," and it
is a recipe for disaster because it will both fail to address our debt
problem and hurt the economy.

Over the years, many economists have
looked at what other countries facing our current debt problems have
done. A review of the academic literature on this issue shows that
successful debt reduction measures are mostly made of spending cuts
rather than a mix of spending cuts and tax increases. I have written on
this topic in the past. And in a new paper, "The Design of Fiscal
Adjustments," Harvard economists Alberto Alesina and Silvia Ardagna
provide still more new evidence that fiscal consolidation based mostly
on the spending side are more likely to lead to a permanent and
long-lasting reduction in the debt-to-GDP ratio.

Second, successful reforms cut in two areas:
social transfers (entitlements in the American context) and the size and
pay of the government workforce. If you think about it, this makes
sense. These are the types of spending cuts that prove a country is
serious about getting its fiscal house in order, because they take on
two of the biggest special interests in any country -- government
employees and seniors.

As Kevin Hassett and Andrew Biggs of the
American Enterprise Institute have shown, a staggering eight of every 10
attempts by countries to reduce their debt-to-GDP ratios are failures.
This means that even in a time of crisis (or especially in a time of
crisis), lawmakers prefer politics over solid, pro-growth policy.
Countries experiencing fiscal trouble generally get there through years
of catering to interest groups and constituencies that favor spending
(on both sides of the political aisle), and their fiscal adjustments
tend to make too many of these same mistakes. The United States seems
poised to do the same.

What is the impact of spending cuts or tax
increases on the economy? First, agreement among economists on the
impact of budget cuts on growth is far from being settled. However, a
few lessons have emerged. Fiscal adjustments achieved through spending
cuts rather than tax increases are less recessionary than those achieved
through tax increases. Alesina and Ardagna's research also reveals that
private investment tends to react more positively to spending-based
adjustments. Thus, they argue that spending cuts are more sustainable
and effective in reducing debt and raising economic growth; thus
expansionary fiscal policy becomes possible again.

Second, tax cuts are more expansionary than
spending increases in the case of a fiscal stimulus. The work of former
Obama Council of Economic Advisers Chairwoman Christina Romer and her
economist husband, David Romer, shows, for instance, that increasing
taxes by 1 percent of GDP for deficit-reduction purposes leads to a 3
percent reduction in GDP. Third, research from the International
Monetary Fund in particular finds that fiscal adjustment based mostly on
tax increases will hurt the economy the most.

The bottom line is that Obama's "balanced
approach" more closely resembles the historic failures -- the fiscal
adjustments that don't successfully reduce a nation's debt-to-GDP ratio.
What's more, history reveals that the balanced approach generally
results in tax increases but rarely delivers on the spending cuts.
That's unfortunate, considering that if the government could actually
collect $1.6 trillion over 10 years from tax increases, this amount
still wouldn't be enough to fill in the projected $6 trillion cumulative
deficit over the period.

Moreover, as Obama himself once said, a tax
increase will likely hurt the economy -- and hence should be avoided,
especially in this weak economy.Here's to hoping that Congress will give spending cuts a chance.

Examiner Contributor Veronique de Rugy is a senior research fellow of the Mercatus Center at George Mason University.